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The liquidity effect in the federal funds market: evidence from daily open market operations

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Listed author(s):
  • Seth B. Carpenter
  • Selva Demiralp

Abstract

We use forecast errors made by the Federal Reserve while preparing open market operations to identify a liquidity effect at a daily frequency in the federal funds market. Unlike Hamilton (1997), we find a liquidity effect on many days of the reserve maintenance period besides settlement day. The effect is non-linear; large changes in supply have a measurable effect, but small changes do not. In addition, a higher aggregate level of reserve balances in the banking system is associated with a smaller liquidity effect during the maintenance period but a larger liquidity effect on the last days of the period.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-61.

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Date of creation: 2004
Handle: RePEc:fip:fedgfe:2004-61
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Web page: http://www.federalreserve.gov/

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Keywords: Federal funds market (United States) ; Federal funds rate ; Liquidity (Economics);

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  1. Bernanke, Ben S. & Mihov, Ilian, 1998. "The liquidity effect and long-run neutrality," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 149-194, December.
  2. Jordi Galí, 1992. "How Well Does The IS-LM Model Fit Postwar U. S. Data?," The Quarterly Journal of Economics, Oxford University Press, vol. 107(2), pages 709-738.
  3. Ben S. Bernanke & Ilian Mihov, 1998. "Measuring Monetary Policy," The Quarterly Journal of Economics, Oxford University Press, vol. 113(3), pages 869-902.
  4. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-370, March.
  5. Hamilton, James D, 1997. "Measuring the Liquidity Effect," American Economic Review, American Economic Association, vol. 87(1), pages 80-97, March.
  6. Seth Carpenter & Selva Demiralp, 2008. "The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 1-24, 02.
  7. Cochrane, John H, 1989. "The Return of the Liquidity Effect: A Study of the Short-run Relation between Money Growth and Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(1), pages 75-83, January.
  8. James A. Clouse & Douglas W. Elmendorf, 1997. "Declining required reserves and the volatility of the federal funds rate," Finance and Economics Discussion Series 1997-30, Board of Governors of the Federal Reserve System (U.S.).
  9. Demiralp, Selva & Farley, Dennis, 2005. "Declining required reserves, funds rate volatility, and open market operations," Journal of Banking & Finance, Elsevier, vol. 29(5), pages 1131-1152, May.
  10. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  11. Leeper, Eric M. & Gordon, David B., 1992. "In search of the liquidity effect," Journal of Monetary Economics, Elsevier, vol. 29(3), pages 341-369, June.
  12. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  13. Adrian R. Pagan & John C. Robertson, 1995. "Resolving the liquidity effect," Proceedings, Federal Reserve Bank of St. Louis, issue May, pages 33-54.
  14. Lawrence J. Christiano, 1991. "Modeling the liquidity effect of a money shock," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 3-34.
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